The Co-op rescue: There was always a better way to deal with bank failure

FROM 2007 to 2009, the UK government, along with the governments of most major developed countries, bailed out bank after bank. They bailed out small banks and big banks, banks with investment banking arms and banks that only did retail, pure banks and building societies. By 2009, the public appetite for explicit bailouts had waned, and from 2010 to 2011 governments switched from direct bank bailouts to re-badging them as “sovereign debt bailouts” – in Greece and Ireland and Portugal. But they were bank bailouts nonetheless.

A number of us who had been involved in the analysis and design of financial regulation complained about this. I don’t simply mean “the usual suspect” libertarian “privatise the army” type free-marketeers, or “Austrian” type fans of “cleansing recession”. I mean mainstream experts, operating in the Financial Services Authority, or the Bank of England, or consulting to regulatory bodies at European Union level. We complained that bailing out banks, when they became financially distressed, would create “moral hazard”. It would destroy the incentives for banks to limit their risk-taking in the future and, in practical terms, take the banking sector – the main allocator of capital in the economy – out of the capitalist system.

This opposition to the bailouts did get some hearing in the public debate, and has spawned significant anti-bailout political movements such as the Tea Party in the US, or the Occupy movement internationally. But in most mainstream commentary there was, and continues to be, a reluctant acceptance that “there was no alternative” – that if we’d not bailed out the banks there would have been economic disaster.

A first observation on this point is that economic disaster has not been averted. If you are going to claim some dreadful act is necessary to “save the world”, you’d better actually save the world. Britain has seen the worst and most sustained recession since the 1920s. Several European countries have unprecedented levels of unemployment, some over 20 per cent. Even the US saw sustained high unemployment. So bailing out the banks didn’t spare us from a dreadful recession.

But more importantly, few of us who opposed bailing out the banks said that the banks should be simply left to collapse in a disorderly manner. What most of us claimed was that governments should introduce Special Administration regimes, similar to those that apply to other systemically-important sectors such as electricity or airports. If banks became distressed, losses should first be imposed on their bondholders, then (if the bondholders were all used up) upon the large depositors – what are now, in the jargon, called “bailins”. But let’s be clear: by definition, a “bank failure” means some creditors – bondholders or depositors – losing money. Bailins are a form of controlled bank failure.

In 2007 to 2009, bailins were hardly debated as an alternative strategy, except by economists such as myself. Those of us who did propose them were told the notion was inconceivable – no government in a modern economy would ever allow a bank creditor to lose any money. Yet what we were told in 2008 was inconceivable has now become the official policy of most international banking regulators – the Basel Committee, the European Commission, the UK government. Precisely the combination we urged in 2007 to 2009 – Special Administration regimes that impose bailins – is now the policy.

The first outing for the no-bailouts approach in the UK was the Southsea Mortgage and Investment bank, in 2011, where uninsured depositors and bondholders took their chances. Denmark had its own variant of a bailin scheme, and in Cyprus we saw large depositors as well as bondholders losing out. The Co-op plan announced yesterday is the latest version, with a £1.5bn balance sheet hole being filled via losses for bondholders and “permanent interest-bearing shares”.

In 2007 to 2009, it wasn’t only the huge banks – RBS and so on – that were bailed out. Numerous small banks, such as Bradford & Bingley or Alliance & Leicester, were also saved. So it wasn’t simply a matter of “too big to fail”. From the case of the Co-op, everyone can now see that there was always an alternative. Indeed, from the RBS IT debacles we have also seen that society can continue with the RBS ATMs shut down for more than a week.

Should there not be a reckoning? What more disastrous policy failure has there ever been than the bank bailouts – a policy that bankrupted multiple governments, from Ireland to Spain, and crippled the UK economy for years? Why did we do it, when, as Co-op shows, bailins were always possible?

Andrew Lilico is the chairman of Europe Economics.

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